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Currency Wars: Perception and Reality

May 2013 Prof. Barry Eichengreen


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Author

Prof. Barry Eichengreen

George C. Pardee and Helen N.

Pardee Professor of Economics

and Political Science

Department of Economics

University of California, Berkeley

Email:

[email protected]

Web Page:

Click here

2

Barry Eichengreen is the George C. Pardee and

Helen N. Pardee Professor of Economics and

Professor of Political Science at the University

of California, Berkeley, where he has taught

since 1987. He is a Research Associate of the

National Bureau of Economic Research (Cam-

bridge, Massachusetts) and Research Fellow of

the Centre for Economic Policy Research (Lon-

don, England). In 1997-98 he was Senior Policy

Advisor at the International Monetary Fund. He

is a fellow of the American Academy of Arts

and Sciences (class of 1997).

Professor Eichengreen is the convener of the

Bellagio Group of academics and economic

officials and chair of the Academic Advisory

Committee of the Peterson Institute of Inter-

national Economics. He has held Guggenheim

and Fulbright Fellowships and has been a


fellow of the Center for Advanced Study in the

Behavioral Sciences (Palo Alto) and the Insti-

tute for Advanced Study (Berlin). He is a regu-

lar monthly columnist for Project Syndicate.

Professor Eichengreen was awarded the Eco-

nomic History Associations Jonathan R.T.

Hughes Prize for Excellence in Teaching in

2002 and the University of California at Berke-

ley Social Science Divisions Distinguished

Teaching Award in 2004. He is the recipient

of a doctor honoris causa from the American

University in Paris, and the 2010 recipient of

the Schumpeter Prize from the International

Schumpeter Society. He was named one

of Foreign Policy Magazine s 100 Leading

Global Thinkers in 2011. He is Immediate Past

President of the Economic History Associa-

tion (2010-11 academic year).
mailto://[email protected]://emlab.berkeley.edu/~eichengr/biosketch.htmlhttp://emlab.berkeley.edu/~eichengr/biosketch.htmlmailto://[email protected]


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Table of contents3

Table of contents

Introduction to Global Financial Institute

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experts with those of leading academic institutions in

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omy. Furthermore, in order to present a well-balanced

perspective, the publications span a wide variety of

academic fields from macroeconomics and finance to

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you to check the Global Financial Institute website regu-

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Co-Chief Investment Officer of Asset Management Dr.

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Mller, and distinguished professors from institutions

like the University of Cambridge, the University of Cali-

fornia Berkeley, the University of Zurich and many more,

all made relevant and reader-friendly for investment

professionals like you.

Introduction ............................................. .............................. 04

1. History Lessons ................................................ ..................... 06

2. Reasoning by Analogy ................................................... .... 08

3. The Fog of War ................................................. ..................... 11

4. References ................................................ .............................. 12



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Introduction

4

The problem of currency wars emerged as both a

major concern and a source of confusion in early 2013.

This once obscure term, first uttered by Brazilian Finance

Minister Guido Mantega in response to the initial round

of quantitative easing in the United States, came into

widespread use following the formation of a new Japa-

nese government under Prime Minister Shinzo Abe in

late 2012. Mr. Abe indicated his intention of pursuing

more aggressively reflationary monetary and exchange

rate policies. This caused the yen to fall by 16% against

the dollar and 19% against the euro between the end of

September, when it became likely that Mr. Abe would

take power, and mid-February 2013, when his appoint-ment of a new Bank of Japan governor was imminent.

Both the term and the concerns to which it referred

therefore migrated to the front pages of the financial

press. A host of additional policymakers some from

emerging markets, such as Alexei Ulyukyev, first deputy

chairman at the Russian Central Bank, and Bahk Jae-

wan, South Koreas finance minister, and others from

advanced countries, like Bundesbank President Jens

Weidmann warned of the adverse consequences of

currency manipulation, Mr. Weidmann referring omi-

nously to an undesirable politicisation of exchange

rates.1 The currency-war problem then became a key

topic at the meetings of the Group of Seven and Group

of Twenty this February, where it was the subject of a

carefully crafted set of communiques.2

But carefully crafted is not the same as clearly under-

stood. The confusion stems from the fact that there is

no widely accepted definition of a currency war. The

term is not found in the leading textbooks of econom-

ics. There is the implication that a currency war is to be

understood by analogy with the concept of a trade war,

in which countries use trade policy to shift spending

toward products produced domestically at the expense

of their neighbours a process that is ultimately futile

insofar as it provokes retaliation. The only difference is

that in the case of a currency war, it is currency policy

rather than trade policy that is being deployed. There

is, however, the analytical problem that while trade

warfare destroys trade, creating a deadweight loss, off-

setting devaluations simply return bilateral exchange

rates to their initial levels with no enduring relative price

effects. It is not clear that the analogy holds water, in

other words.

Similarly, there is the implication that a currency warcan be said to have broken out when one or more

countries engages in beggar-thy-neighbour competi-

tive currency depreciation. But it is not clear in this

case whether all policies that result in currency or

exchange-rate depreciation are necessarily competitive

or beggar-thy-neighbour. Just because a country sees

its exchange rate depreciate, is it necessarily engaged

in a currency war?

Probably the most widely accepted definition of what

constitutes a currency war is what countries did in the

1930s. Starting in 1931, one country after another

depreciated its currency. Since currencies were

pegged to gold rather than to one another, countries

depreciated by abandoning their pre-existing gold pari-

ties and allowing the domestic currency price of gold

to rise. This consequently had the effect of also raising

the domestic currency price of foreign currencies still

pegged to gold at prevailing parities.3

As the story is conventionally told, this enhanced the

competitiveness of countries depreciating their curren-

cies but worsened that of the remaining gold-standard

Currency Wars: Perception and RealityProf. Barry EichengreenMay 2013

Currency Wars: Perception and Reality Global Financial Institute

1Quoted in Randow and Schneeweiss (2013).2See Group of Seven (2013) and Group of Twenty (2013).3The gold parity referred to the weight of gold of specified purity in the national monetary unit as specified by law or

statute of a country said to be on the gold standard.


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5 Currency Wars: Perception and Reality

countries. This saddled the latter with overly strong

exchange rates, creating pressure for them to respond

tit for tat, as they ultimately did. After five years of com-

petitive devaluations, exchange rates had returned to

levels very close to those prevailing in early 1931. No

country succeeded in engineering a sustained improve-

ment in competitiveness or, it is argued, achieved

faster economic growth. But there were a variety of

other adverse consequences ranging from height-

ened exchange rate uncertainty that disrupted trade

and production to the imposition of trade barriers and

exchange controls by countries with overvalued curren-

cies and weakened balances of payments.4 It is not an

exaggeration to say that popular accounts blame the

currency wars of the 1930s for aggravating the political

tensions that made it more difficult for countries to col-

laborate in averting the military and diplomatic conflicts

that led ultimately to World War II.5

In fact, this conventional narrative is oversimplified and

misleading in important respects. This in turn meansthat todays debate over currency wars, because it is

heavily informed by that narrative, is itself oversimpli-

fied and misleading. The modern literature empha-

sises that the policy changes associated with currency

depreciation in the 1930s were not actually zero sum.

To the contrary, those policy changes left all countries

better off relative to the status quo ante, in which policy

did not change and exchange rates did not move. But

this was not well understood at the time. As a result,

the point is not understood today by those advancing

the conventional story.

In part, contemporary misunderstanding arose from

the fact that interwar governments did a poor job of

communicating their intentions. In part it arose from

the fact that they did a poor job of implementing their

policies; they could have done much more to accentu-

ate the positive-sum aspects. And in part it arose from

the fact that policymakers continued to view their cur-

rent situation through the lens of past problems, failing

to acknowledge that circumstances and therefore the

appropriate policies had changed.

The same factors are again present today, once more distort-

ing the debate over currency policies. Policymakers have

done a poor job communicating their intentions. They could

have done more to accentuate positive-sum aspects of their

actions. And, along with market participants, they have had a

tendency to view policies through the distorting lens of pastproblems rather than current circumstances. Understanding

these shortcomings of the present debate and correcting the

resulting misapprehensions would go a long way toward solv-

ing the currency war problem.

4These negative side effects were highlighted by Ragnar Nurkse (1944) in his influential contemporary account, which

helped to clear the way for the Bretton Woods System of pegged-but-adjustable exchange rates. A recent, somewhat

revisionist treatment is Eichengreen and Irwin (2010).5 See for example Kennedy (1999).



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1. History Lessons


The background to the currency and exchange rate

problems of the 1930s was, of course, the depression

and deflation that started in 1929. In turn, that depres-

sion and deflation must be understood in the context of

the gold standard, the monetary regime providing the

structure for global monetary and financial affairs.6

The 1920s monetary regime was a gold-exchange stan-

dard rather than a pure gold standard. Central banks

and governments operated under statutes obligat-

ing them to back their monetary liabilities with gold

and convertible foreign exchange.7 Other than this

provision for holding reserves in the form of foreign

exchange, the regime had many of the features of a text-

book gold standard. International financial flows were

unrestricted. With the capital account of the balance

of payments open, domestic interest rates could not

deviate significantly from those in the rest of the world.

If domestic policymakers sought to depress rates fur-

ther, capital would migrate to foreign financial markets

where they were higher, causing the central bank tolose gold and foreign exchange reserves, and threaten-

ing the maintenance of gold convertibility. This is the

standard open-economy trilemma.8 With exchange

rates pegged and capital markets open, central banks

had limited monetary policy room for manoeuvre.

The gold-exchange standard had been put back in place

in the 1920s after roughly a decade of suspension, dur-

ing which a number of current and former belligerents

had suffered high inflation.9 That experience in turn

shaped their expectations of risks and outcomes in the

event that gold convertibility was again suspended.

As it happened, deflation rather than inflation turned

out to be the immediate danger.10 When it developed

after 1929, central banks and governments had little

freedom of action. As long as they remained on the

gold standard, they could not unilaterally take steps

to stem the fall in prices. They could not unilaterally

cut interest rates to encourage borrowing and spend-

ing. Injecting liquidity in order to support a distressed

banking system threatened to fatally weaken the cur-

rency. Running budget deficits rekindled fears, inher-

ited from the 1920s, that central banks would be pres-

sured to monetise public debts. Governments were

therefore forced to cut public spending and raise taxes

in order to preserve confidence in their exchange rate

commitments.

It might be thought that these policies of austerity, pur-

sued in the face of depression and deflation, could not

be sustained indefinitely. Indeed, they could not. Brit-

ain was the first major country to abandon them and

depreciate its currency. It had a Labour government

that could not agree on budgetary economies and high

unemployment that rendered the central bank reluctant

to raise interest rates further in order to stem capital

flight.11 It suspended gold convertibility in September

1931, and the pound quickly fell from $4.86 to a low of

$3.40, from which it recovered modestly before stabi-lising. Some two dozen other economies, principally

members of the Commonwealth and Empire and British

trading partners, quickly followed suit. The next shoe

to drop was Japan, whose finance minister Korkiyo

Takahashi implemented an aggressively expansion-

ary monetary policy that pushed down the yen start-

ing in December. President Franklin Delano Roosevelt

embargoed gold exports on March 5th, 1933, his first

full day in office. He made that embargo permanent

in April and actively pushed up the dollar price of gold

(pushed down the dollar exchange rate) from October.

A number of U.S. trade partners, principally in Latin

America, followed the dollar down. In January 1934,

when the dollar was again stabilised against gold, the

sterling/dollar exchange rate was back to roughly the

level prevailing before September 1931.

These efforts by Britain, the U.S., and Japan to depre-

ciate sterling, the dollar, and the yen made life more

6

As I argued in Eichengreen (1992), on which the remainder of this section draws.7Typically at ratios of 33 to 40 per cent.8See Obstfeld, Shambaugh and Taylor (205).9The hyperinflations in Germany, Austria, Hungary, and Poland being extreme cases in point.10Describing the origins of the global deflation would take us too far afield; in this, see Bernanke (1995) and Eichen-

green (2004).11That Labour government was succeeded by a National government which agreed on budgetary economies in August,

but by this time it was too late.

32

48



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difficult for countries still on the gold standard. (That

these are the same three countries currently under

attack for being engaged in currency war is presum-

ably a coincidence.) Having lost international competi-

tiveness, these so-called gold-bloc countries saw their

balances of payments accounts weaken and gold flow

out of their central banks. Forced to raise interest rates

to defend the reserve position rather than cutting them

to support the economy, their depressions deepened.

The result was not an equilibrium in either the eco-

nomic or political sense. Economically, the condition

of domestic financial institutions continued to worsen.

Politically, opposition welled up against policies of aus-

terity. The remaining members of the gold bloc pro-

gressively fell by the wayside. Czechoslovakia and Italy

devalued in 1934, Belgium in 1935, Poland, France, the

Netherlands, and Switzerland in 1936, returning their

exchange rates to roughly the same levels against the

dollar and sterling that prevailed before 1931. These

competitive devaluations gave rise to a good deal of

damaging exchange rate and financial volatility, but atthe end of the day, it is said, they changed nothing.

Such is the conventional narrative. The modern litera-

ture on exchange rate policy in the 1930s, beginning

with Eichengreen and Sachs (1985), disputes this view

that the exchange rate policies of the 1930s were with-

out positive effect. While currency depreciation did

switch demand toward domestic goods and away from

their foreign substitutes, this was not its exclusive or

even its principal impact. Rather, abandoning the com-

mitment to peg the exchange rate allowed countries

to replace the deflationary measures of the preceding

period with reflationary monetary policies. Going off

the gold standard was a credible way of signaling this

commitment to prioritise price stability over exchange

rate stability.

Thus, six months after abandoning the gold standard,

the Bank of England began cutting interest rates; by

July 1932 these had reached the historically low level

of 2%, inaugurating a new era of cheap money. The

Swedish government and Riksbank replaced the gold

standard with an explicit price level target. In Japan,

Takahashi supplemented his reflationary monetary

policy with an increase in public spending and instruc-

tions that the Bank of Japan purchase the resulting

increase in the public debt. In the U.S., FDR used his

bombshell message to the World Economic Confer-

ence of June-July 1933 to signal that he was unwilling

to restore the gold standard. He was not prepared to

privilege exchange rate stability (what he referred to in

that message as the old fetishes of international bank-

ers). The bombshell message may have made interna-

tional cooperation on trade policy, security policy, and

other matters more difficult, but it was a strong signal

of a durable change in the monetary regime.

These new policies had other important effects apart

from their impact on exchange rates. Lower inter-

est rates encouraged interest-rate sensitive forms of

spending, in the U.K. for example, where the literature

refers to the housing boom of the 1930s. 12 They put

upward pressure on asset prices which, other things

equal, stimulated investment spending. By haltingdeflation, they stemmed the rise in debt burdens and

squeeze on profits. By creating expectations of higher

future prices, they encouraged households to shift

consumption from the future to the present. By giv-

ing central banks more freedom of action, they allowed

them to intervene as lenders of last resort to limit bank

distress.13 And insofar as the policies had these stabi-

lising effects on the initiating country, they encouraged

residents to spend more on foreign as well as domestic

goods. Currency devaluation by an individual country

may have had negative spillovers on its neighbours via

the exchange rate channel, but it had positive spillovers

via these interest rate, asset price, and expectations

channels. Even if the negative exchange rate spillovers

dominated when a single policy was taken in isolation,

once the entire round of exchange rate changes was

complete those negative spillovers were gone and only

the positive interest rate, asset price, and expectation

effects remained.

These conclusions are, of course, inconsistent with the

presumption that monetary policy was impotent in the

1930s because interest rates were at the zero lower

12 See Middleton (2010) for references.13The cross-country evidence can be found in Grossman (1994).



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bound.14 Cross-country comparisons, calibration exer-

cises, and national case studies, all using data from the

1930s, have combined to overturn this presumption.15

These studies highlight that interest rates were still

significantly above zero prior to the change in policy

regime; the change therefore gave central banks fur-

ther room to cut. They remind us that even when nomi-

nal interest rates are near zero, central banks can still

affect the real interest rates on which allocation deci-

sions depend through the expectations channel by

using forward guidance and asset purchases to create

expectations of inflation rather than deflation. FDRs

gold purchases and Takahashis government bond pur-

chases can be thought of as analogous to quantitative

easing, while the Bank of Englands commitment to

keep interest rates low and the Riksbanks commitment

to target the price level can be thought of as forward

guidance.

Modern studies thus conclude that countries abandon-

ing the gold standard and allowing their currenciesto depreciate recovered most quickly from the 1930s

depression. Recovery was, however, less than vigor-

ous. Countries abandoning the gold standard and

depreciating their currencies were reluctant to imple-

ment aggressively reflationary policies. In Britain, for

example, the Bank of England, concerned that the ster-

ling exchange rate could collapse in the absence of its

golden anchor, took three full quarters to convince itself

that cheap money was safe and to cut interest rates to

2%. Even then it remained reluctant to cut them fur-

ther. FDR, although depreciating the dollar by 50%, put

the U.S. back on the gold standard at the now higher

gold price in January 1934, contrary to the advice of

John Maynard Keynes and others. In the subsequent

period, the Treasury repeatedly sterilised gold inflows,

limiting the growth of money and credit. Central banks

and governments could not free themselves of the

specter of the 1920s inflations and thus were reluctant

to make full use of their newfound monetary room for

manoeuvre.

As a result, the beggar-thy-neighbour effect of currency

depreciation tended to dominate the positive spillovers

transmitted through now lower interest rates and infla-

tionary expectations. And the failure of policymakers

to more clearly explain their intentions which were

not to beggar their neighbours but to stabilize their own

prices, economies, and financial systems caused their

motives to be widely misunderstood.

Thus, to the extent that there was a currency problem

in the 1930s, it stemmed not from the decision of coun-

tries abandoning the gold standard to reflate, but from

the failure of the countries of the gold bloc to do like-

wise. That failure was rooted, as noted above, in ear-

lier experience with high inflation in France, Belgium,

Poland, and the Central European countries that now

clung to the gold standard with the help of exchange

control.16 Policymakers and their constituents contin-

ued to perceive current economic and financial circum-

stances through the lens of past problems, with pro-

foundly negative consequences.

The problem in the 1930s, then, was not too much cur-

rency warfare, but too little.

Many of these points have analogues in the current

debate. First, there is the view, implicit in the critiques

of emerging market policymakers, that the unconven-

tional monetary policies of advanced-country central

banks are ineffectual. Monetary policy, they allege, has

lost its potency now that interest rates are at the zero

lower bound, just as it allegedly lost its potency in the

1930s. Only the negative side-effects, it follows, are

left.

While there is less than full consensus on the efficacy

of unconventional monetary policies at the zero lower

bound, a growing body of literature studying different

episodes suggests that such policies are not entirely

without effect. Oda and Ueda (2005) and Ugai (2006)

14 A presumption that is popularly cited as explaining Keyness discovery of the importance of using activist fiscalpolicy in a liquidity trap.15 See, respectively, Bernanke and James (1991), Eggertsson (2008), and Romer (1992) for examples.16 In the cases of Switzerland and the Netherlands, an additional motive was the desire not to jeopardise the position of

Zurich and Amsterdam as international financial centres and the power of the banking lobby.


2. Reasoning by Analogy


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analyse the impact of the Bank of Japans experience

with quantitative easing between 2001 and 2006 and

conclude in favor of small but noticeable impacts on

medium- and long-term interest rates. Gagnon, Raskin,

Remarche, and Sack (2011) report evidence, derived

using a variety of methodological approaches, of posi-

tive effects of quantitative easing in the United States.

Krishnamurthy and Vissing-Jorgensen (2010) look at

low frequency variations in the supply of long-term

Treasury bonds like those that would follow from quan-

titative easing and identify effects on interest rates on

other relatively safe assets. Krishnamurthy and Vissing-

Jorgensen (2011), disaggregating further, find evidence

of a signaling channel, an expected inflation channel,

and a demand-for-long-term-safe-assets channel trans-

mitting effects of both the first and second rounds of

quantitative easing by the Federal Reserve. Looking

back at Operation Twist in the 1960s, Swanson (2011)

finds a small but significant impact on long-term inter-

est rates operating through the portfolio rebalancing

channel. Joyce, Lasaosa, Stevens, and Tong (2010)similarly find evidence of the operation of the portfo-

lio rebalancing channel in the response of gilt prices

to large-scale asset purchases by the Bank of Eng-

land starting in March 2009. In a companion paper,

Kapetanios, Mumtaz, Stevens, and Theodoridis (2010)

conclude that those Bank of England purchases had an

effect on the level of real GDP of around 1 % and

raised the annual rate of CPI inflation by about 1 per-

centage points at its peak. Different studies consider

different episodes and arrive at different point esti-

mates, but as a group they are inconsistent with the

view that unconventional monetary policies are with-

out effect. This casts doubt on the assertion by some

observers based in emerging markets that such policies

should simply be abandoned.

Second, there is the view that unconventional monetary

policies operate only by pushing down currencies, with

beggar-thy-neighbour consequences for other coun-

tries. To be sure, the exchange rate channel can be

important for switching expenditure toward domestic

goods. Insofar as this channel dominates, the effect

will be to beggar thy neighbour. Just as in the 1930s, to

the extent that central banks fail to complement open

mouth operations pushing down the real exchange rate

with open market operations and other asset purchases

pushing down real interest rates, their neighbours will

have correspondingly more reason to complain about

the spillover effects on output and employment in other

countries.

But the exchange rate channel can also be important

for signaling the policy authorities commitment to

do what it takes to hit their inflation target. Svensson

(2003) refers to the combination of a price-level target

path, a zero interest rate commitment and, importantly,

currency depreciation and a commitment to maintain-

ing a level for the exchange rate as the foolproof way

of ending deflation. Insofar as ending the deflation and

avoiding the extended period of economic stagnation to

which it can give rise is good not just for the initiating

country but also its trade and financial partners, posi-

tive spillovers on other countries from depreciation of

its exchange rate may still dominate.

The studies referred to earlier in this section suggest

that unconventional monetary policies also operate

through the portfolio rebalancing channel that leads

to changes in the term structure of interest rates. IMF

(2011) finds that portfolio-rebalancing-related interest-

rate effects dominated the other negative cross-border

spillover effects of QE1 and QE2 in other words, that

the spillover impact on foreign output was positive on

balance, the complaints of emerging market policymak-

ers notwithstanding.

Third, there are complaints about other negative side

effects of unconventional monetary policies. The worry

is that quantitative easing is encouraging renewed

financial excesses in advanced countries and emerg-

ing markets alike. Risks are being allowed to build up.

Equity markets in the United States are becoming richly

valued as investors facing near-zero interest rates on

safe assets stretch for yield by purchasing riskier instru-

ments. The natural process of deleveraging by the

household and financial sectors needed to produce a

safer and more stable economy is being frustrated, the



10/14


implication follows.

This view has an analogue in the liquidationist

response to the Great Depression.17 U.S. policymak-

ers inside and outside the Fed worried that monetary

accommodation would cause the development of an

even larger Wall Street boom and bubble, leading sub-

sequently to an even larger crash. Herbert Hoovers

Treasury Secretary Andrew Mellon famously argued

that restraint was necessary to teach speculators

a lesson and purge the rottenness out of the sys-

tem.18 Similar views were advanced by Austrian and

other Continental European economists from Hayek to

Schumpeter.

The modern literature on the Great Depression and on

financial crises generally acknowledges that activism

has risks but suggests that inaction in the face of cri-

sis also has a downside. And to the extent that pol-

icy activism in response to crisis encourages financial

excesses, these are best addressed by tightening super-vision and regulation of financial markets, not by pre-

mature abandonment of supportive monetary policies.

Some recent studies have questioned this separation

principle they have questioned whether there exists

an adequate array of monetary and regulatory instru-

ments, so that monetary policy can be assigned to infla-

tion and growth while regulation is assigned to financial

stability.19 Maybe not, but if not the call should be for

policymakers to develop a wider array of instruments,

not for central banks and governments to abandon the

pursuit of all other valid goals in the interest of financial

stability.

The same goes for the complaint that unconventional

monetary policies in the advanced countries are feed-

ing financial excesses in emerging markets. The worry

itself is not without foundation: As Chen, Filardo, He

and Zhu (2011) show, quantitative easing in the United

States has had a strong impact on credit growth,

asset prices, and capital inflows in emerging markets.

But the first-best response for policymakers in those

countries is not to jawbone the Federal Reserve and

Bank of Japan to abandon quantitative easing, which

would make for slower global and even possibly slower

emerging-market growth, but to tighten their own

supervision and regulation of financial markets. And to

the extent that conventional regulatory instruments are

not up to the task, emerging market policy makers can

resort to capital inflow taxes and controls as a second

line of defence against financial excesses resulting from

foreign policies.20

Similarly, to the extent that low interest rates in the

advanced countries encourage capital inflows into

emerging markets that fan inflation, result in currency

overvaluation, and create worries of overheating, the

first-best response is not for officials there to pressure

advanced country central banks to abandon their low

interest rate policies but to adjust their own policies

appropriately. The first-best response is for emerging

markets to tighten fiscal policy. Tightening fiscal policy

puts downward pressure on domestic spending. It putsdownward pressure on asset valuations. It means less

inflation, other things equal. It means lower interest

rates and, therefore, smaller capital inflows and less

pressure for real exchange rate appreciation. By reduc-

ing sovereign debt burden, it puts the economy in a

stronger position going forward.

The objection here is that political constraints make

it difficult to adjust fiscal policy, which is even more

politicised than monetary policy. Maybe so, but then

the call should be to make it easier to implement opti-

mal adjustments of fiscal policy in emerging markets

by strengthening automatic stabilisers or delegating

aspects of fiscal policy to an independent fiscal council,

not to insist that advanced country central banks aban-

don the pursuit of price stability and recovery.

The European Central Bank, spokesmen for which have

complained about how the policies of other central

banks have produced an uncomfortably strong euro

exchange rate, is in a different position. In contrast to

17See DeLong (1990).18 As quoted in Hoover (1952).19 See Committee on International Economic Policy and Reform (2011).20This is the justification of capital inflow restrictions as a second-best form of financial regulation first developed, if I

am correct, in Eichengreen and Mussa (1998).



11/14


emerging markets, spokesmen for which have similarly

complained that their exchange rates are uncomfort-

ably strong, the Eurozone does not currently suffer from

excessive inflation, frothy asset markets, or risk of eco-

nomic overheating to the contrary. Eurozone inflation

fell to 2% in January in line with the ECBs target, while

core inflation at 1.2% is running below that. The fourth

quarter of 2012 saw Eurozone GDP shrink by 0.6%.

The standard policy prescription for a central bank

engaged in flexible inflation targeting and worried by

an overly strong exchange rate would be to join the cur-

rency wars. In the event, the ECB is not a conventional

inflation-targeting central bank. It has a mandate to

hold inflation at or below its target of 2% but not to pur-

sue other goals. The European public, whose approval

lends the ECBs policies political legitimacy, continues

to worry about inflation, which was yesterdays prob-

lem but is less obviously todays or even tomorrows.

The analogy with the deflationary 1930s when central

banks were haunted by the spectre of inflation in anearlier decade, in turn feeding their reluctance to take

more aggressive monetary action is direct. How the

ECB squares this circle will have implications not just

for the global currency wars, but for the future of the

Eurozone itself.

A final analogy with the 1930s is the failure of policy

makers in countries following unconventional monetary

policies to adequately communicate their goals and

strategies. In late December, Japans incoming prime

minister made a series of comments about the desir-

ability of resisting a strong yen that were interpreted

in terms of the desirability of a weaker yen exchange

rate. By focusing on the exchange rate rather than

on measures to push up the price level, reduce inter-

est rates, and encourage spending, those comments

fanned fears that the strategy was intentionally beggar

thy neighbour. In its first policy statement for 2013,

the Bank of Japan then signaled its responsiveness to

the new governments desires, but announced that it

would consider further ramping up its programme of

asset purchases only in 2014. By creating expectations

that it might acquiesce to a weaker yen exchange rate

but that it would only take additional steps to foster

expectations of higher prices, lower real interest rates,

and more spending 12 or more months in the future,

that statement further heightened fears abroad that the

new strategy was exchange-rate-centered and beggar

thy neighbour.

It may be that the essence of Japans new monetary

policy strategy is the higher inflation target of 2% and

that the Bank of Japan will make a concerted effort to

achieve it, creating expectations of a higher future price

level and encouraging additional spending by Japanese

consumers something that would be more likely to

have positive spillovers for other countries. If so, this

fact needs to be conveyed more clearly to avoid fanning

fears of currency war.

Currency war is now a standard trope in journalis-

tic accounts of monetary policy. But what exactly

constitutes currency warfare remains unclear. Not

every economic policy that is associated with a weaker

exchange rate is undesirable, and not every domestic

policy associated with a weaker exchange rate nec-

essarily redounds to the disfavor of other countries.

Officials warning of currency wars would do better to

distinguish positive from negative effects of the foreign

monetary policies of which they complain. They would

do well to consider the alternatives. Would emerging

markets really be better off if advanced countries at

risk of deflation and recession abandoned their uncon-

ventional policies? Policymakers in emerging markets

could spend less time complaining about advanced

country policies and more time identifying and imple-

menting an appropriate policy response. Policymakers

in advanced countries, for their part, need to do a better

job of communicating the intent of their policies. Only

then are we likely to see our way through the fog of war.


3. The Fog of War


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